SSY Sunlink Health Systems

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

(Dollars in thousands, except per share and admissions data)

Forward-Looking Statements

This Quarterly Report and the documents that are incorporated by reference in this Annual Report contain certain forward-looking statements within the meaning of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all statements that do not relate solely to historical or current facts and may be identified by the use of words such as “may,” “believe,” “will,” “seeks to”, “expect,” “project,” “estimate,” “anticipate,” “plan” or “continue.” These forward-looking statements are based on the current plans and expectations and are subject to a number of risks, uncertainties and other factors which could significantly affect current plans and expectations and our future financial condition and results. Throughout the notes to the consolidated financial statements, SunLink Health Systems, Inc., and its consolidated subsidiaries are referred to on a collective basis as “SunLink”, “we”, “our”, “ours”, “us” or the “Company.” This drafting style is not meant to indicate that SunLink Health Systems, Inc. or any particular subsidiary of SunLink Health Systems, Inc. owns or operates any asset, business, or property. Healthcare services, pharmacy operations and other businesses described in this filing are owned and operated by distinct and indirect subsidiaries of SunLink Health System, Inc. These forward-looking statements are based on current plans and expectations and are subject to a number of risks, uncertainties and other factors that could significantly affect current plans and expectations and our future financial condition and results. These factors, which could cause actual results, performance, and achievements to differ materially from those anticipated, include, but are not limited to:

General Business Conditions

Operational Factors

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Liabilities, Claims, Obligations and Other Matters

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Regulation and Governmental Activity

Dispositions, Acquisition and Renovation Related Matters

The foregoing are significant factors we think could cause our actual results to differ materially from expected results. However, there could be additional factors besides those listed herein that also could affect SunLink in an adverse manner. You should read this Quarterly Report completely and with the understanding that actual future results may be materially different from what we expect. You are cautioned not to unduly rely on forward-looking statements when evaluating the information presented in this Quarterly Report or our other disclosures because current plans, anticipated actions, and future financial conditions and results may differ from those expressed in any forward-looking statements made by or on behalf of SunLink.

We have not undertaken any obligation to publicly update or revise any forward-looking statements. All of our forward-looking statements speak only as of the date of the document in which they are made or, if a date is specified, as of such date. We disclaim any obligation or undertaking to provide any updates or revisions to any forward-looking statement to reflect any change in our expectations or any changes in events, conditions, circumstances or information on which the forward-looking statement is based, except as required by applicable law. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing factors and the other risk factors set forth elsewhere in this report and/or in our Annual Report on Form 10-K.

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Business Strategy: Operations, Dispositions and Acquisitions

The business strategy of SunLink is to focus its efforts on improving the operations, services and profitability of its existing Healthcare Services and Pharmacy businesses. While the Company intends primarily to pursue its business strategy of improving its operations, services and profitability of its existing businesses, subject to available capital and other resources, the Company also intends to pursue growth by selective acquisitions in the healthcare and pharmacy segments. We believe, however, the COVID-19 pandemic has resulted in substantial additional uncertainties and risks in our businesses which are not subject to estimation at this time, particularly because the COVID-19 is novel in nature, uncertain in duration, and materially affected by government actions related to the pandemic. In response to the pandemic, the Company has discontinued certain services, laid off or furloughed employees where necessary, reduced cash outlays where possible, and deferred other strategic activities. Our ability to resume the pursuit of our normal business strategy, including growth initiatives, will depend on the effect of, among other things, the nature, extent and timing of the COVID-19 pandemic and government actions in response thereto.

The Company expects to use existing cash primarily to sustain it operations during the COVID-19 pandemic, for growth initiatives when available and appropriate, and for other general corporate purposes. There is no assurance that further dispositions of assets or any acquisitions will be authorized by the Company’s Board of Directors or, if authorized, that any such transactions will be completed. Although the Company believes certain portions in its Healthcare Services segment as well as its Pharmacy segment continue to under-perform, the Company is not currently offering any of its businesses for sale.

COVID-19 Pandemic and CARES Act Funding

COVID-19 was declared a global pandemic by the World Health Organization on March 11, 2020. We have been monitoring the COVID-19 pandemic and its impact on our operations, and we have taken significant steps intended to minimize the risk to our employees and patients. Certain employees have been working remotely, but we believe these remote work arrangements have not materially affected our ability to maintain critical business operations, which are being conducted substantially in accordance with our understanding of applicable government health and safety protocols and guidance issued in response to the COVID-19 pandemic, although such protocols and guidance are recent, rapidly changing and at times, unclear. Nevertheless, as in many healthcare environments, we have experienced COVID-19 illness, including deaths, and some employees have tested positive and were placed on leave or in quarantine. We believe the effect of the COVID-19 pandemic and public and governmental responses to it have negatively affected our last seven quarters results.

In late December 2020, we began receiving allotments of COVID-19 vaccine and have vaccinated patients, providers, employees, and staff in accordance with the protocols and guidelines in the states where we operate. Not all such individuals have been vaccinated to date and some individuals have not consented to vaccination. The Company and its subsidiaries are currently developing and will implement plans to vaccinate employees to the extent required by the final rules issued by OSHA and CMS. The Company believes the vaccine mandates may result in the loss of certain staff, including clinical staff, which may impact the Company’s ability to maintain the current levels of service.

In our Healthcare businesses, we have experienced material reductions in demand and net revenues due to the COVID-19 outbreak. There continues to be reduced current demand for certain hospital services, and for extended care, rehabilitation center and nursing home admissions, and clinic visits. The availability and cost of medical supplies have adversely affected our Healthcare businesses, and we continue to monitor supplies and seek additional sources of many supply items. A reduction in the availability of qualified employees has also occurred, and, despite good faith efforts to do so, we have not yet been able to rehire or fully replace staff which were previously furloughed, laid off or retired.

Since the beginning of the COVID-19 pandemic, our Pharmacy business has experienced reduced sales trends in certain areas, increased costs and reduced staff. Many of our primary physician referral sources have operated at reduced capacity, and until these referral sources are at full capacity, we believe the COVID-19 pandemic will continue to affect the demand for DME products and Retail and Institutional Pharmacy drugs and products. Reductions in employee hours have been made in response to the lower demand. Extended care facilities and rehabilitation centers, nursing homes and other customers of our Institutional Pharmacy services continue to be adversely affected by the COVID-19 pandemic. Our Institutional Pharmacy services have experienced increased

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costs and operational inefficiencies due to measures taken to protect our employees and by access controls and other restrictions implemented by our institutional customers. The impact of the COVID-19 pandemic has negatively affected our supply processes, especially with respect to access to respiratory equipment and certain personal protective equipment and cleaning products.

Our Healthcare and Pharmacy segments have received approximately $5,446 in general and targeted Provider Relief Funds ("PRF") during the period April 1, 2020 through September 30, 2021 under the CARES Act, which was enacted in March 2020 in response to the COVID-19 pandemic. The PRF distributions have been accounted for as government grants, and a total of $4,933 have been recognized since April l, 2020 as other income under the gain contingency recognition method.

During the quarter ended June 30, 2020, our Healthcare and Pharmacy segments received $3,234 in PPP loans provided under the CARES Act. These loans were forgivable upon compliance with conditions specified under the PPP loan program. As of September 30, 2021, all our PPP loans have been forgiven.

The Taxpayer Certainty and Disaster Tax Relief Act of 2020, enacted December 27, 2020, made a number of changes to employer retention tax credits previously made available under the CARES Act, including modifying and extending the Employee Retention Credit ("ERC") for the six calendar months ending June 30, 2021. As a result of such legislation, the Company qualified for ERC for the first and second calendar quarters of 2021 due to the decrease in its gross receipts and has applied for ERC of $3,586 through amended quarterly payroll tax filings for the applicable quarters.

PRF distributions are not subject to repayment provided we are able to attest to and comply with the terms and conditions of the funding, including demonstrating that the funds received have been used for designated, allowable healthcare-related expenses and capital expenditures attributable to COVID-19 and for "Lost Revenues" as defined by HHS. We continue to monitor compliance with the terms and conditions of the PRF and the impact of the pandemic on our revenues and expenses. If we are unable to attest to or comply with current or future terms and conditions, and there is no assurance we will be able to do so, our ability to retain some or all of the PRF received may be impacted, and we may have to return the unutilized portion of those funds, if any, in the future.

Going forward, the Company is unable to determine the extent to which the COVID-19 pandemic will continue to affect its assets and operations. Our ability to make estimates of the effect of the COVID-19 pandemic on revenues, expenses or changes in accounting judgments that have had or are reasonably likely to have a material effect on our financial statements is currently limited. The nature and extent of the effect of the COVID-19 pandemic on our balance sheet and results of operations will depend on the severity and length of the pandemic; government actions to mitigate the pandemic's effect; regulatory changes in response to the pandemic, especially those that affect our hospital, extended care, rehabilitation center, nursing home, clinics, and our pharmacy operations; existing and potential government assistance that may be provided; and the requirements of PRF receipts, including our ability to retain such PRF received.

For additional discussion of the risks presented by the COVID-19 pandemic to our results, see Risk Factors in Part II, Item 1A of this Form 10-Q.

Critical Accounting Estimates

The preparation of financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect reported amounts and related disclosures. We consider an accounting estimate to be critical if it requires assumptions to be made that were uncertain at the time the estimate was made; and changes in the estimate or different estimates that could have been made could have a material impact on our consolidated results of operations or financial condition.

Our critical accounting estimates are more fully described in our 2021 Annual Report on Form 10-K and continue to include the following areas: receivables – net and provision for doubtful accounts; revenue recognition and net patient service revenues; goodwill, intangible assets and accounting for business combinations; professional and general liability claims; and accounting for income taxes.

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The Healthcare Services segment in the current year is composed of one hospital, one extended care and rehabilitation center and a subsidiary which provides information technology services to outside customers and SunLink subsidiaries. Healthcare Services net revenues increased $34, or 1%, for the three months period ended September 30, 2021 compared to net revenues for the comparable prior year period. Hospital patient days and clinic visit increases were offset by a 9 % decrease in extended care patient days.

Pharmacy segment net revenues for the three months period ended September 30, 2021 increased $69, or 1% from the three months period ended September 31, 2020. Durable Medical Equipment sales increased 6.5% for the three month period ended September 30, 2021 from the prior year period as orders increased 18%  this year, primarily due to higher respiratory equipment orders. Retail pharmacy sales decreased 3.5%  for the three month period ended September 30, 2021 from the prior year period due to lower revenue per script despite a 0.8% increase in retail pharmacy scripts filled. Institutional pharmacy sales decreased 1.29% for the three month period ended September 30, 2020 from the prior year period due to the loss of one larger institutional customer.

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Costs and expenses, including depreciation and amortization, were $11,518 and $10,745 for the three months ended September 30, 2021 and 2020, respectively.

Cost of goods sold decreased as a percent of net revenues for the three month period ended September 30, 2021 due to decreased sales of retail and institutional pharmacy drugs this year which have a higher relative cost than DME products. Salaries, wages, and benefits increased as a percent of net revenues for the three months period ended September 30, 2021 compared to same period last fiscal year due to higher salaries and wages due to labor market conditions, operating challenges of labor allocation relating to the pandemic, including contract labor, and  higher employee health claims expenses. Supplies expenses increase this year due to increased purchase prices due to market demand and supply disruptions. Purchased services costs increased this year due to increased costs of  fuel, the outsourcing at a Healthcare Services facility of cleaning and dietary services and increased cost of software support services of the Healthcare Services segment. Other operating expenses increased as percent of net revenues during the fiscal quarter this year due to the increased cost of insurance. Depreciation expense also increased as a percentage of net revenue this year due to the $2,595 of capital expenditures last fiscal year.

Operating Profit (Loss)

The Company reported an operating loss of $993 for the three month period ended September 30, 2021 compared to an operating loss of $323 for the three month period ended September 31, 2020. Such operating loss for the three month period ended September 31, 2021 was primarily a result of higher labor costs, purchased services and insurance costs, not covered by the slightly higher revenues.

Forgiven of PPP loans and accrued interest

              During the quarter ended September 30, 2021, $2,972 of our PPP loans and related $38  of accrued interest were forgiven by the SBA and $3,010 was recorded as income relating to PPP loan forgiveness for the quarter ended September 30, 2021.

Other Income – Federal Stimulus – Provider relief funds

As part of the CARES ACT, two subsidiaries have received PRF payments.  The Company recognized $0 and $31 during the three months ended September 30, 2021 and 2020 respectively.

Interest Income (Expense) -Net

Interest  expense, net, was $14 for the three months period ended September 30, 2021 compared to interest income, net, of $7 for the three months period ended September 30, 2020, respectively.

Income Taxes

Income tax expense of $2 (all state taxes) and $0 was recorded for continuing operations for the three months ended September 30, 2021 and 2020, respectively. 

Of the CARES Act provisions, the most material income tax considerations related to the Company are related to the amounts for ERC and amounts received as general and targeted PRF. Based on the latest published IRS guidance as of the preparation of the September 30, 2021 financial statements, PRF (to the extent the applicable terms and conditions required to retain the funds are met “Retainable PRF”) are fully includable in taxable income in the

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Company’s tax returns in the fiscal year received. ERC are included in tax income in the Company’s tax returns in the quarter in which the payroll expenses for which the credits offset are deductible. ERC results in qualified wages being disallowed as a deduction for the portion of the wages paid equal to the sum of the payroll tax credit taken in the associated quarter. For amounts received and forgiven under the PPP loans, due to the enactment of the Consolidated Appropriations Act, 2021, on December 27, 2020, Congress specifically allows the deduction of any expenses associated with forgiven PPP loan proceeds. It is the Company’s assumption at September 30, 2021 that all PPP Loan associated expenses will be deductible for income tax.

In accordance with the Financial Accounting Standards Board Accounting Standards Codification (“ASC”) 740, we evaluate our deferred taxes quarterly to determine if adjustments to our valuation allowance are required based on the consideration of available positive and negative evidence using a “more likely than not” standard with respect to whether deferred tax assets will be realized. Our evaluation considers, among other factors, our historical operating results, our expectation of future results of operations, the duration of applicable statuary carryforward periods and conditions of the healthcare industry. The ultimate realization of our deferred tax assets depends primarily on our ability to generate future taxable income during the periods in which the related temporary differences in the financial basis and the tax basis of the assets become deductible. The value of our deferred tax assets will depend on applicable income tax rates.

At September 30, 2021, consistent with the above process, we evaluated the need for a valuation allowance against our deferred tax assets and determined that it was more likely than not that none of our deferred tax assets would be realized. As a result, in accordance with ASC 740, we recognized a valuation allowance of $6,961 against the deferred tax asset so that there is no net long-term deferred income tax asset or liability at September 30, 2021. We conducted our evaluation by considering available positive and negative evidence to determine our ability to realize our deferred tax assets. In our evaluation, we gave more significant weight to evidence that was objective in nature as compared to subjective evidence. Also, more significant weight was given to evidence that directly related to our current financial performance as compared to less current evidence and future performance.

The principal negative evidence that led us to determine at September 30, 2021 that all the deferred tax assets should have full valuation allowances was the projected current fiscal year tax loss disregarding unusual items associated with the CARES Act discussed above, history of losses as well as the underlying negative business conditions for rural healthcare businesses in which our Healthcare Services Segment businesses operate and the Federal income tax net operating loss carry-forward of approximately $16,847.

For Federal income tax purposes, at September 30, 2021, the Company had approximately $16,847 of estimated net operating loss carry-forwards available for use in future years subject to the limitations of the provisions of Internal Revenue Code Section 382. These net operating loss carryforwards expire primarily in fiscal 2023 through fiscal 2038; however, with the enactment of the Tax Cut and Jobs Act on December 22, 2017, federal net operating loss carryforwards generated in taxable years beginning after December 31, 2017 now have no expiration date. The Company’s returns for the periods prior to the fiscal year ended June 30, 2018 are no longer subject to potential federal and state income tax examination.

Earnings (Loss) from Continuing Operations after Income Taxes

Earnings from continuing operations after income tax was $2,006 for the three months ended September 30, 2021 as compared to a loss from continuing operations after income tax of $291 for the three months ended September 30, 2020. The increased earnings from continuing operations this year compared to the prior year was due to income recognized for PPP loan forgiveness this year, offset in part by the current period operating loss.

Loss from Discontinued Operations after Income Taxes

The loss from discontinued operations after income taxes was $67 for the three month period ended September 30, 2021 compared to a loss from discontinued operations after income taxes of $49 for the three months period ended September 30, 2020.

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Discontinued Operations

Sold Hospitals and Nursing Homes– Subsidiaries of the Company have sold substantially all the assets of four hospitals (“Sold Facilities”) during the period July 2, 2012 to March 17, 2019. The loss before income taxes on the Sold Facilities results primarily from the effects of retained professional liability insurance and claims expenses and settlement of a lawsuit.

Life Sciences and Engineering Segment —SunLink retained a defined benefit retirement plan which covered substantially all of the employees of this segment when the segment was sold in fiscal 1998. Effective February 28, 1997, the plan was amended to freeze participant benefits and close the plan to new participants. Pension expense and related tax benefit or expense is reflected in the results of operations for this segment for the three  months ended September 30, 2021 and 2020, respectively.

Net Earnings (Loss)

Net income for the three months period ended September 30, 2021 was $1,939 ($0.27 per fully diluted share) as compared to a net loss of $340 (or a loss of $0.05 per fully diluted share) for the three months period ended September 30, 2020.

Liquidity and Capital Resources

Overview

Our primary source of liquidity is unrestricted cash on hand, which was $8,933 at September 30, 2021. The Company and its subsidiaries currently are funding working capital needs primarily from cash on hand. From time -to-time, we may, nevertheless, seek to obtain financing for the liquidity needs or the Company or individual subsidiaries based on anticipated need. However, currently, the Company’s ability to raise capital (debt or equity) in the public or private markets on what it considers acceptable terms is uncertain, and due to the COVID-19 pandemic and related factors, may be non-existent.

CARES Act Funds - The CARES Act was enacted by the U.S. government on March 27, 2020. Among the relief provided to health care providers under the CARES Act are grants under PRF and forgivable loans under PPP. We have received a total of $8,680 under the CARES Act programs consisting of $5,446 in general and targeted PRF and $3,234 of PPP loans. During the first two calendar quarters of 2021, the Company became eligible for, and we applied for $ 3,586 of ERC through amended quarterly payroll tax filings. In October 2021, the Company applied with HHS to receive Phase 4 Provider Relief Funds. We do not know if or in what amount we will receive any additional PRF under Phase 4.

Subject to the effects, risks and uncertainties associated with the COVID-19 pandemic and our ability to retain the CARES funds described above, we believe we have adequate financing and liquidity to support our current level of operations through the next twelve months.

As of September 30, 2021, we had outstanding debt of $81 of capital lease debt.

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         At September 30, 2021, the Company has approximately $966 of commitments for future capital expenditures for our Trace hospital under its Trace Forward Capital Plan which was announced in March 2021. This Plan expands, upgrades and improves the physical plant, patient care, ancillary services and support areas of the Trace hospital. In addition to the $966 committed to the Trace Forward Capital Plan, at September 30, 2021, the Company also has committed future cash expenditures of approximately $70 for replacement computer equipment of the Pharmacy segment and approximately $700 for future purchases of capitalizable durable medical equipment by the Pharmacy segment (to be rented to customers) through the end of fiscal 2022. The actual amount which will be expended is difficult to predict due to various factors including varying demand for such equipment as well as the availability given current supply sourcing challenges. The Company anticipates funding such expenditures primarily from cash on hand. Other cash expenditures for the next 12 months currently are expected to be in-line with expenditures for the quarter ended September 30, 2021. There have been no material changes outside the ordinary course of business relating to our upcoming cash obligations which have occurred during the three months ended September 30, 2021. Other than with respect to scheduled cash expenditures (based on current operating levels) for long-term debt, operating leases, and interest on current outstanding debt, as well as continued uncertainties relating to the continuing impact of the COVID-19 pandemic, the Company is currently unaware of other trends or unusual uncertainties that are likely to cause a material change in its cash expenditures in periods beyond the next twelve months. See Notes 7, 9, 10, and 11 to our financial statements. The Company is also unaware of events that are reasonably likely to cause a material change in the relationship between its costs and revenues (such as known or reasonably likely future increases in costs of labor or materials, price increases or inventory adjustments, beyond those discussed herein); however, we are unable to predict with any degree of accuracy whether, or the extent to which, recent inflationary price trends in 2021 are transitory or reflect the beginning of an inflationary cycle.

Related Party Transactions

A director of the Company is a member of a law firm which provides services to SunLink. The Company expensed an aggregate of $50 and $55 for legal services to this law firm in the three months ended September 30, 2021 and 2020, respectively.  Included in the Company’s condensed consolidated balance sheets at September 30, 2021 and June 30, 2021 is $48 and $21, respectively, of amounts payable to this law firm.